{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Spring 2005 -Questions for TBS 907 Tutorial 3- Capital Struc

Spring 2005 -Questions for TBS 907 Tutorial 3- Capital...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
TBS 907 TUTORIAL 3- CAPITAL STRUCTURE SOLUTIONS QUESTION 1 (a) Laurel Hardy Operating Earnings $180,000 $180,000 Debenture Interest 36,000 $180,000 $144,000 Laurel is value at $2 m while Hardy is valued at $1.8m ($1.2m equity and $600k debt). In an MM world both companies should have the same value as they have identical earnings streams in terms of value and risk. If we assume prefect capital markets were there are no taxes or transaction costs and that personal debt is a perfect substitute for corporate debt, then Roach should sell his interest in Laurel and invests in Hardy while keeping his level of financial risk the same. Sell 6% of Laurel for $120,000 Invest in : Hardy Equity $80,000 Hardy Debt $40,000 $120,000 By investing in equity and debt in proportion to their market value, financial risk is nil, i.e. the same as Laurel. Before income was 6% of $180,000 $10,800 After Income is: equity- 8/120 x $144,000 9,600 Debt – 6% of $40,000 2,400 $12,000 I.e. income has increase by $1,200 while risk remains unchanged. (b) The arbitrage opportunity will gradually diminish as the value of Laurel will decrease and the value of Hardy increases until an equilibrium point has been reached. (c) Rational investors would arbitrage in this situation, moving from the higher valued firm to the lower valued firm, thus increasing their income for the same investment, whilst holding their level of risk constant. This process would continue until all the firms in the same risk class would sell for the same total rate of return irrespective of how they were financed. Thus, in a such a world WACC is a constant and is not affected by changes in capital structure, and projects of the same risk class can be appraised using the current WACC ( including the cost of equity in an all equity firm) irrespective of the way in which the project is to be financed. This result depends, however, on the restrictive assumptions TBS 907- T UTORIAL 3- CAPITAL STRUCTURE P AGE 1 OF 4
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
mentioned in (a) and whether relaxation of these assumptions has a significant impact on the conclusion QUESTION 2 QUESTION 3 QUESTION 4 (a) The company plans to raise $30m. It needs to maintain a 50% debt, 50% equity balance. With Retained Earnings $3m Raise New Equity $12m And new Debt $15 m QUESTION 5 Each of the three reasons given by the President may be criticized: a) If we assume that there really is a gain from leverage, then the value of the firm will
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

Page1 / 4

Spring 2005 -Questions for TBS 907 Tutorial 3- Capital...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon bookmark
Ask a homework question - tutors are online